What s Wrong with Banking? and What to Do About It

Transcription

1 What s Wrong with Banking and What to Do About It Anat Admati Stanford University June, 2015 https://www.gsb.stanford.edu/faculty research/excessive leverage What s Wrong with Banking? System is too fragile and inefficient due to Opacity, complexity, and interconnectedness Excessive reliance on (short term) debt Severe governance problems and distortions that are not solved in markets. Flawed laws and regulations. Politics and lack of accountability. 1

12 What s Inside America s Large Banks? Jesse Eisinger and Frank Partnoy, Atlantic, Jan 2013 Quote executives: large banks [are] complete black boxes. Investors: uninvestable. Kevin Warsh: Investors can t truly understand the nature and quality of the assets and liabilities. They can t readily assess the reliability of the capital to offset real losses. They can t assess the underlying sources of the firms profits. The disclosure obfuscates more than it informs, and the government is not just permitting it but seems to be encouraging it. The Fortress Balance Sheet Myth Accounting measures don t show crisis High market values can mislead From: Andrew Haldane, Capital Discipline, January 2011) 24 12

13 What About Governance and Controls? JPM Dimon: The "portfolio hedge" was "flawed, complex, poorly reviewed, poorly executed and poorly monitored. Controls were not in place. JPM restated results: traders "mis marked positions Who is responsible? Who is accountable? Several finance practices are wasteful if not fraudulent. Luigi Zingales, Does Finance Benefit Society? Jan/2015. Fines: Cost of Doing Business? Top 20 banks paid $235B since

14 Are Auditors Doing Their Job? None of the bailed out, failed, or forcibly acquired financial services firms in US or UK received a "going concern" qualification from their auditors prior to needing significant financial support from taxpayers and/or nationalization (i.e. AIG, Citi, RBS). External auditor PwC gave JPM a clean opinion on its financials and internal controls over reporting for Let Them Fail? Fail is too late: instability would precede insolvency Bankruptcy or resolution are disruptive and harmful in the best case, whoever is paying the direct costs. Won t work if entire industry is weak. Enormous legal challenges cross border. FSB 2014 Key Attribute of Cross Border Resolution has huge wish list of legal and regulatory steps. IMF 2014: failure of cross border SIFI not a viable option 14

17 The Mantra Equity is Expensive To whom? Why? Only in banking? From Banking Textbook Bank capital is costly because, the higher it is, the lower will be the return on equity for a given return on assets. Frederic S. Mishkin, 2013, The Economics of Money, Banking and Financial Markets, 3 rd Edition, p. 227, 17

20 Debt Creates Conflicts of Interest and Distorts When debt is in place, shareholders no longer maximize total firm value and may overinvest or underinvest: take negative NPV projects that benefit themselves, harm creditors and lower the value of the firm. forego positive NPV projects that would benefit creditors and increase total value of the firm. Covenants attempt to counter the incentives, otherwise inefficiency reflected in cost of borrowing. Another Force: The Leverage Ratchet Effect What about subsequent funding decisions once debt is in place? Conflict with creditors means shareholders favor leverage increase even if it reduces firm value and even if new debt just be junior to existing debt. resist leverage reduction even when it would enhance firm value. Leverage creates a distortion in future leverage decisions See The Leverage Ratchet Effect, Admati, DeMarzo, Hellwig and Pfleiderer (2014, under revision) 20

21 The Leverage Ratchet Effect explains why distressed firms don t recapitalize, instead make payouts to shareholders and issue more debt, which increases the risk of costly bankruptcy. is stronger than underinvestment; shareholders avoid recapitalization no matter how beneficial it is to firm. interacts and reinforces other agency conflicts. implies that without ability to commit to future funding decisions, leverage creates inefficiencies that lower the total value of the firm (in addition to any collateral harm). Some Facts Non banks make risky, long term, illiquid investments. Without regulations US average: 70% equity/assets (market value). Nonbanks, including REITs and hedge funds, rarely have less than 30% equity (if healthy) Profits are popular source of unborrowed funding. Berkshire Hathaway, Google, Microsoft. Banks with (sometimes much) less than 10% equity make routine payouts to shareholders. 21

25 Banks are Special in having passive creditors, such as depositors, and many supporters, including in central banks, governments, elsewhere. getting away with so much recklessness. Perverse Subsidies Reducing subsidies is not a social cost. Blanket subsidies to all debt of TBTF firms are distorting and harmful, perversely enabling and rewarding inefficient growth and more recklessness. If subsidies are deemed desirable we should look for different delivery methods. More equity corrects distortions in credit markets. See Admati July 2014 Senate testimony, Chapter 9, BNC, Sections 4, 9, Fallacies, Irrelevant Facts, and Myths 25

26 How Much Equity? Basel II and Basel III Capital Requirements Tier 1 capital Ratio: Relative to risk weighted assets: Basel II: 2%, Basel III: 4.5% 7%. Definitions changed on what can be included. Leverage Ratio: Relative to total assets: Basel II: NA Basel III: 3%. US: 5% for large BHC, 6% for insured subs. Requirements based on flawed analyses of tradeoffs. Is Basel III Tough? Tripling the previous requirements sounds tough, but only if one fails to realize that tripling almost nothing does not give one very much. Basel III, the Mouse that Did Not Roar, Martin Wolf, Financial Times, Sep 13, 2010 How much capital should banks issue? Enough so that it doesn't matter Running on Empty, John Cochran, Wall Street Journal, March 1,

35 The Lobbying Cry Every dollar of capital is one less dollar working in the economy. Steve Bartlett, Financial Services Roundtable, Sept

36 Credit and Growth will Suffer Credit and growth suffered dramatically in the crisis and haven t fully recovered. Was too much equity the cause? just about whatever anyone proposes, no matter what it is, the banks will come out and claim that it will restrict credit and harm the economy. It s all bullshit. Paul Volcker to Senator Ted Kaufman, Jan. 15, 2010 The Payoff: Why Wall Street Always Wins, Jeff Connaughton, 2012 Recall: Growth Has Suffered and Not Recovered Loss in the UK Potential GDP Trillions of 2000 Pounds Actual GDP Jan 07 May 08 Sep 09 Feb 11 Jun 12 Nov 13 Mar 15 Aug 16 36

37 13% 12% 11% 10% Unemployment Unemployment Rate 9% 8% 7% 6% 5% 4% Euro Area UK US Science is what we have learned about how to keep from fooling ourselves. Richard Feynman True for economists? See Chameleons: The Misuse of Theoretical Models in Finance and Economics, Paul Pfleiderer, 2014 Distorted maps are bad at guiding travel. 37

38 While it often seems that financial stability has no natural constituency, that constituency is actually all of us including policy makers as well as businesses, households, [and] financial firms. Eric Rosengren, President & CEO, Federal Reserve Bank of Boston, Money Market Funds Still Need Reform, Wall Street Journal, April 26, 2012 The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests. The Rothschild brothers of London,

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